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Why McDonald's Is Taking On Starbucks Over Coffee

At the end of this month, Starbucks(NASDAQ:SBUX) is likely to post a result that will draw little attention, but is intriguing for its larger implications: The company will overtake McDonald's(NYSE:MCD) for the first time in pre-tax earnings in Japan. McDonald's, of course, has struggled in Japan recently. Its 50-owned Japanese subsidiary recently announced that it was closing 74 stores, or about 2.3% of its total store count, due to declining customer demand. Starbucks' demand arc in Japan is quite another story -- the company has gone from zero to more than 1,000 stores in less than 20 years.

The two businesses' trajectories in Japan are emblematic of a more global phenomenon. On nearly every continent, McDonald's is struggling to maintain its growth momentum, while Starbuck's has seemingly effortlessly posted a recent annual growth rate of 11.1%. McDonald's is dealing with a number of factors crimping its revenues, the most prominent of which is a sea change in consumer preferences, for higher-quality, fast-casual establishments over quick-service chains like McDonald's. Yet recently, the company has zeroed in on Starbucks as a threat to its business. Here's Chief Operating Officer Tim Fenton during the company's most recent earnings call, discussing the last quarter's problems and mentioning Starbucks but not by name:

... we lost some share based on our insights to non-traditional competitors, cafés, and bakeries."

As Bloomberg reported a few days after this call, internally, McDonald's has challenged its operators to protect its breakfast segment by winning what it deems a "coffee war" with Starbucks.

Will McDonald's wrench significant amounts of market share from Starbucks with this new push? It's doubtful. But CEO Donald Thompson understands that sometimes, to push forward a big strategic objective, you need to humanize the objective and create a villain that your troops can rally around to defeat.

The point of appearing to go to warIn this case, the strategic objective is simply to increase coffee-driven visits in the U.S., as such visits usually occur at breakfast, which accounts for 25% of company revenue. The strategy is likely informed by the chain's recent experience in Canada. In 2008, career McDonald's executive John Betts took over the company's Canadian division. Along with upgrading McDonald's Canadian locations to a more contemporary aesthetic, Betts implemented a plan to draw more Canadians into McDonald's outlets with coffee, because Canada, similar to the U.S., is a coffee culture.

Most notably, McDonald's Canada began giving coffee away for free, first running this promotion in 2009. The emphasis on coffee won over skeptical Canadians, and since then, coffee sales in Canada have tripled, and breakfast has seen double-digit sales increases for the last five years. As Betts archly stated in 2012: "When you change someone's coffee habit, you have got them."

In the U.S., McDonald's can't expect to triple its coffee sales in five years by giving away free coffee. When Starbucks was but a single crammed location in Pike Place Market in Seattle, and the company's global footprint existed only as a network of neurons in Howard Shultz's brain, McDonald's provided by default the most widely available retail cup of coffee in the country. Today, the landscape has changed irrevocably. What McDonald's can expect by pushing a "gold-standard cup of coffee with every visit" is to regain traction with wavering customers.

As CFO Pete Bensen stated during the company's most recent earnings conference call, "If we lose relevance in coffee, then we are going to lose the transaction which yields food purchase." In other words, if the company can direct more of the legions in need of a coffee fix through its arches during breakfast, the rest of the transaction will fall into place. It's interesting how well Woody Allen's famous quote that "80% of life is showing up" applies to a simple and well-reasoned corporate strategy like this one.

Toward this goal, McDonald's has quietly laid the groundwork for increasing the quality, supply, and promotion of its coffee. Last year, the company announced that it was investing $6.5 million to assist more than 13,000 farmers in Guatemala and other South American countries, to scale up volume of high-grade arabica coffee beans, as well as to assist small-scale farmers with sustainable agricultural methods.

As for promotion, the company's well-publicized push into packaged coffee through its new partnership with Kraft might be construed as an attempt to compete with Starbucks in the retail grocery venue, but it's more immediately about heightening coffee brand perception. It is betting that U.S. incentives such as its "$1 any size coffee" at breakfast, coupled with McDonald's-branded coffee in grocery stores, will keep its coffee top of mind versus Starbucks and other competitors. If increased business at breakfast eventually leads to additional sales of packaged coffee, as well as more non-breakfast visits, the company will take it as a bonus.

Vegetable & Fontiago Breakfast Sandwich. Courtesy Starbucks.

A reaction from SeattleHow is Starbucks responding to McDonald's sudden pressure on the coffee front? By ramping up its new breakfast offerings, of course. This month, the company is introducing four new premium breakfast sandwiches, with enticing names including "Slow-Roasted Ham and Swiss" and "Vegetable & Fontiago." Tearing off a sheet from the McDonald's strategy notebook, Starbucks will offer a free Grande-sized brewed coffee with the purchase of a breakfast sandwich from March 12-14. Of course, Starbucks also has a larger strategy in mind, which is to generate a larger transaction per customer. Yet it speaks to the importance of the breakfast market that given a few more disappointing sales quarters from McDonald's, or any sign of Starbucks' vaunted growth slowing, and these two giants could be headed for confrontation after all.